Kế toán, kiểm toán - Chapter 12: Capital budgeting decisions

Capital Budgeting Decisions Chapter12Capital BudgetingHow managers plan significant outlays on projects that have long-term implications such as the purchase of new equipment and introduction of new products.Typical Capital Budgeting DecisionsPlant expansionEquipment selectionEquipment replacementLease or buyCost reductionTypical Capital Budgeting DecisionsCapital budgeting tends to fall into two broad categories . . .Screening decisions. Does a proposed project meet some present standard of acceptance?Preference decisions. Selecting from among several competing courses of action. Time Value of MoneyBusiness investments extend over long periods of time, so we must recognize the time value of money.Investments that promise returns earlier in time are preferable to those that promise returns later in time.Time Value of Money A dollar today is worth more than a dollar a year from now since a dollar received today can be invested, yielding more than a dollar a year from now.Interest and the Time Value of Money If $100 is invested today at 8% interest, how much will you have in two years?At the end of one year: $100 + 0.08$100 = (1.08)$100 = $108At the end of two years: $108 + 0.08$108 = (1.08)$108 = (1.08)[(1.08)$100] = (1.08)2 $100 = $116.64Interest and the Time Value of Money If P dollars are invested today at the annual interest rate r, then in n years you would have Fn dollars computed as follows: Fn = P(1 + r)nInterest and the Time Value of Money The present value of any sum to be received in the future can be computed by turning the interest formula around and solving for P: Interest and the Time Value of Money A bond will pay $100 in two years. What is the present value of the $100 if an investor can earn a return of 12% on investments?P = $100 (0.797) P = $79.70 Interest and the Time Value of Money A bond will pay $100 in two years. What is the present value of the $100 if an investor can earn a return of 12% on investments?Present Value = $79.70 What does this mean?If $79.70 is put in the bank today, it will be worth $100 in two years.In that sense, $79.70 today is equivalent to $100 in two years.Interest and the Time Value of Money Let’s verify that if we put $79.70 in the bank today at 12% interest that it would grow to $100 at the end of two years. Time Value of MoneyA bond will pay $100 in two years. What is the present value of the $100 if an investor can earn a return of 12% on investments?We can also determine the present value using present value tables.Time Value of MoneyExcerpt from Present Value of $1 Table in the Appendix to Chapter 12Time Value of MoneyPresent value factor of $1 for 2 periods at 12%.$100 × 0.797 = $79.70 present valueQuick Check  How much would you have to put in the bank today to have $100 at the end of five years if the interest rate is 10%?a. $62.10b. $56.70c. $90.90d. $51.90Quick Check  How much would you have to put in the bank today to have $100 at the end of five years if the interest rate is 10%?a. $62.10b. $56.70c. $90.90d. $51.90$100  0.621 = $62.10Time Value of Money123456$100$100$100$100$100$100An investment that involves a series of identical cash flows at the end of each year is called an annuity.Time Value of Money Lacey Inc. purchased a tract of land on which a $60,000 payment will be due each year for the next five years. What is the present value of this stream of cash payments when the discount rate is 12%?Time Value of MoneyWe could solve the problem like this . . .Look in Appendix B of this Chapter for thePresent Value of an Annuity of $1 TableTime Value of MoneyWe could solve the problem like this . . .$60,000 × 3.605 = $216,300Quick Check  If the interest rate is 14%, how much would you have to put in the bank today so as to be able to withdraw $100 at the end of each of the next five years?a. $34.33b. $500c. $343.30d. $360.50Quick Check  If the interest rate is 14%, how much would you have to put in the bank today so as to be able to withdraw $100 at the end of each of the next five years?a. $34.33b. $500c. $343.30d. $360.50$100  3.433 = $343.33Quick Check  If the interest rate is 14%, what is the present value of $100 to be received at the end of the 3rd, 4th, and 5th years?a. $866.90b. $178.60c. $ 86.90d. $300.00Quick Check  If the interest rate is 14%, what is the present value of $100 to be received at the end of the 3rd, 4th, and 5th years?a. $866.90b. $178.60c. $ 86.90d. $300.00$100(3.433-1.647)= $1001.786 = $178.60or$100(0.675+0.592+0.519)= $1001.786 = $178.60Typical Cash OutflowsRepairs andmaintenanceIncrementaloperatingcostsInitialinvestmentWorkingcapitalTypical Cash InflowsReductionof costsSalvagevalueIncrementalrevenuesRelease ofworkingcapitalIllustration of the NPV MethodCarver Hospital is considering the purchase of an attachment for its X-ray machine. No investments are to be made unless they have an annual return of at least 10%.Will we be allowed to invest in the attachment?Illustration of the NPV MethodIllustration of the NPV MethodPresent valueof an annuityof $1 tableIllustration of the NPV MethodBecause the net present value is equal to zero,the investment in the attachment for the X-ray machine provides exactly a 10% return.Quick Check  Suppose that the investment in the attachment for the X-ray machine had cost $4,000 and generated an increase in annual cash inflows of $1,200. What is the net present value of the investment?a. $ 800b. $ 196c. $(196)d. $(800)Quick Check  Suppose that the investment in the attachment for the X-ray machine had cost $4,000 and generated an increase in annual cash inflows of $1,200. What is the net present value of the investment?a. $ 800b. $ 196c. $(196)d. $(800)-$4,000+$1,2003.170 = -$4,000 + $3,804= -$196Choosing a Discount RateThe firm’s cost of capital is usually regarded as the most appropriate choice for the discount rate.The cost of capital is the average rate of return the company must pay to its long-term creditors and stockholders for the use of their funds.The Net Present Value MethodTo determine net present value we . . .Calculate the present value of cash inflows,Calculate the present value of cash outflows,Subtract the present value of the outflows from the present value of the inflows.The Net Present Value MethodGeneral decision rule . . .The Net Present Value MethodLet’s look athow we usepresent value tomake businessdecisions.The Net Present Value MethodLester Company has been offered a five year contract to provide component parts for a large manufacturer.The Net Present Value MethodAt the end of five years the working capital will be released and may be used elsewhere by Lester.Lester Company uses a discount rate of 10%.Should the contract be accepted?The Net Present Value MethodAnnual net cash inflows from operationsThe Net Present Value MethodThe Net Present Value MethodPresent value of an annuity of $1 factor for 5 years at 10%.The Net Present Value MethodPresent value of $1 factor for 3 years at 10%.The Net Present Value MethodPresent value of $1 factor for 5 years at 10%.The Net Present Value MethodAccept the contract because the project has a positive net present value.Quick Check DataDenny Associates has been offered a four-year contract to supply the computing requirements for a local bank.The working capital would be released at the end of the contract.Denny Associates requires a 14% return.Quick Check  What is the net present value of the contract with the local bank?a. $150,000b. $ 28,230c. $ 92,340d. $132,916Quick Check  What is the net present value of the contract with the local bank?a. $150,000b. $ 28,230c. $ 92,340d. $132,916Expanding the Net Present Value MethodTo compare competing investment projects we can use the following net present value approaches:Total-costIncremental costThe Total-Cost ApproachWhite Co. has two alternatives: (1) remodel an old car wash or, (2) remove it and install a new one.The company uses a discount rate of 10%.The Total-Cost ApproachIf White installs a new washer . . .Let’s look at the present valueof this alternative.The Total-Cost ApproachThe Total-Cost ApproachThe Total-Cost ApproachThe Total-Cost ApproachThe Total-Cost ApproachThe Total-Cost ApproachIf we install the new washer, the investment will yield a positive net present value of $83,202.The Total-Cost ApproachIf White remodels the existing washer . . .Let’s look at the present valueof this second alternative.The Total-Cost ApproachThe Total-Cost ApproachThe Total-Cost ApproachThe Total-Cost ApproachIf we remodel the existing washer, we will produce a positive net present value of $56,405.The Total-Cost ApproachBoth projects yield a positive net present value.However, investing in the new washer will produce a higher net present value than remodeling the old washer.The Incremental-Cost Approach Under the incremental-cost approach, only those cash flows that differ between the two alternatives are considered.Let’s look at an analysis of the White Co. decision using the incremental-cost approach.The Incremental-Cost Approach$300,000 new - $175,000 remodel = $125,000The Incremental-Cost Approach$80,000 remodel - $50,000 new = $30,000The Incremental-Cost Approach$60,000 new - $45,000 remodel = $15,000The Incremental-Cost ApproachWe get the same answer under either thetotal-cost or incremental-cost approach.Quick Check  Consider the following alternative projects. Each project would last for five years. Project A Project B Initial investment $80,000 $60,000 Annual net cash inflows 20,000 16,000 Salvage value 10,000 8,000 The company uses a discount rate of 14% to evaluate projects. Which of the following statements is true?a. NPV of Project A > NPV of Project B by $5,230b. NPV of Project B > NPV of Project A by $5,230c. NPV of Project A > NPV of Project B by $2,000d. NPV of Project B > NPV of Project A by $2,000Quick Check  Consider the following alternative projects. Each project would last for five years. Project A Project B Initial investment $80,000 $60,000 Annual net cash inflows 20,000 16,000 Salvage value 10,000 8,000 The company uses a discount rate of 14% to evaluate projects. Which of the following statements is true?a. NPV of Project A > NPV of Project B by $5,230b. NPV of Project B > NPV of Project A by $5,230c. NPV of Project A > NPV of Project B by $2,000d. NPV of Project B > NPV of Project A by $2,000Least Cost DecisionsIn decisions where revenues are not directly involved, managers should choose the alternative that has the least total cost from a present value perspective.Let’s look at the Home Furniture Company.HomeFurnitureLeast Cost DecisionsHome Furniture Company is trying to decide whether to overhaul an old delivery truck now or purchase a new one.The company uses a discount rate of 10%.HomeFurnitureLeast Cost DecisionsHere is information about the trucks . . .Least Cost DecisionsLeast Cost DecisionsHome Furniture should purchase the new truck.Ranking Investment ProjectsProfitability Present value of cash inflows index Investment required=The higher the profitability index, themore desirable the project.Other Approaches toCapital Budgeting DecisionsOther methods of making capital budgeting decisions include . . .The Payback Method.Simple Rate of Return.The Payback MethodThe payback period is the length of time that it takes for a project to recover its initial cost out of the cash receipts that it generates.When the net annual cash inflow is the same each year, this formula can be used to compute the payback period:Payback period = Investment required Net annual cash inflowThe Payback MethodManagement at The Daily Grind wants to install an espresso bar in its restaurant.The espresso bar:Costs $140,000 and has a 10-year life.Will generate net annual cash inflows of $35,000.Management requires a payback period of 5 years or less on all investments.What is the payback period for the espresso bar?The Payback MethodPayback period = Investment required Net annual cash inflowPayback period = $140,000 $35,000Payback period = 4.0 yearsAccording to the company’s criterion, management would invest in the espresso bar because its payback period is less than 5 years.Quick Check  Consider the following two investments: Project X Project Y Initial investment $100,00 $100,000 Year 1 cash inflow $60,000 $60,000 Year 2 cash inflow $40,000 $35,000 Year 3-10 cash inflows $0 $25,000 Which project has the shortest payback period?a. Project Xb. Project Yc. Cannot be determinedQuick Check  Consider the following two investments: Project X Project Y Initial investment $100,00 $100,000 Year 1 cash inflow $60,000 $60,000 Year 2 cash inflow $40,000 $35,000 Year 3-10 cash inflows $0 $25,000 Which project has the shortest payback period?a. Project Xb. Project Yc. Cannot be determined Project X has a payback period of 2 years. Project Y has a payback period of slightly more than 2 years.Which project do you think is better?Evaluation of the Payback MethodIgnores the time valueof money.Ignores cashflows after the paybackperiod.Short-comingsof the PaybackPeriod.The Simple Rate of Return MethodDoes not focus on cash flows -- rather it focuses on accounting income.The following formula is used to calculate the simple rate of return:-Simple rateof return= Incremental Incremental expenses, revenues including depreciationInitial investmentThe Simple Rate of Return MethodManagement of The Daily Grind wants to install an espresso bar in its restaurant.The espresso bar:Cost $140,000 and has a 10-year life.Will generate incremental revenues of $100,000 and incremental expenses of $65,000 including depreciation.What is the simple rate of return on the investment project?The Simple Rate of Return MethodSimple rateof return $100,000 - $65,000 $140,000 = 25%=The simple rate of return method is not recommended for a variety of reasons, the most important of which is that it ignores the time value of money.Quick Check  Inland Airlines is considering the purchase of an aircraft for $20 million that would last for 10 years and generate incremental revenues of $9 million per year and incremental expenses, excluding depreciation, of $5 million per year. What is the simple rate of return on the aircraft?a. 10%b. 15%c. 20%d. 25%Quick Check  Inland Airlines is considering the purchase of an aircraft for $20 million that would last for 10 years and generate incremental revenues of $9 million per year and incremental expenses, excluding depreciation, of $5 million per year. What is the simple rate of return on the aircraft?a. 10%b. 15%c. 20%d. 25%[$9 – ($5 + $2)] / $20 = 15%Postaudit of Investment ProjectsA postaudit is a follow-up after the project has been approved to see whether or not expected results are actually realized.End of Chapter 12